Model Answer
0 min readIntroduction
The High-Powered Money (HPM) theory, also known as the Money Multiplier theory, explains how the central bank can influence the money supply in an economy. Developed by Milton Friedman and Anna Schwartz, it posits that the money supply is directly and proportionately related to the monetary base – the sum of currency in circulation and commercial banks’ reserves held at the central bank. This theory gained prominence in the mid-20th century as a tool for understanding and controlling inflation and economic fluctuations. Understanding this theory is crucial for comprehending the mechanisms through which monetary policy impacts the broader economy.
Understanding High-Powered Money
High-powered money (HPM) refers to the total monetary base, which is the sum of currency in circulation (C) and commercial banks’ reserves (R) held at the central bank. It’s considered ‘high-powered’ because it has the potential to create a multiple expansion of the money supply through the fractional reserve banking system. The money supply (M) is thus a multiple of the HPM, determined by the money multiplier (m).
The relationship can be expressed as: M = m * HPM, where m = (1 + C/R). Here, C represents currency held by the public and R represents the reserves held by commercial banks.
Components of High-Powered Money
- Currency in Circulation (C): This includes physical currency (notes and coins) held by the public.
- Commercial Banks’ Reserves (R): These are the deposits that commercial banks hold with the central bank, plus the vault cash they keep on hand. Reserves are held to meet reserve requirements set by the central bank and to provide liquidity for day-to-day transactions.
The Money Multiplier Mechanism
The money multiplier effect arises from the fractional reserve banking system. When a bank receives a deposit, it is required to keep a certain percentage as reserves (the reserve ratio) and can lend out the rest. This lending creates new deposits in other banks, which in turn lend out a portion of those deposits, and so on. This process continues, creating a multiple expansion of the money supply. The size of the multiplier depends on the reserve ratio and the public’s preference for holding currency versus deposits.
Assumptions of the High-Powered Money Theory
The HPM theory relies on several simplifying assumptions:
- Fixed Currency Ratio (C/D): The theory assumes that the ratio of currency held by the public to deposits remains constant. This implies that people’s preference for holding cash versus depositing it in banks doesn’t change.
- Fixed Reserve Ratio (R/D): The theory assumes that the ratio of reserves held by banks to deposits remains constant. This means banks consistently adhere to the central bank’s reserve requirements and don’t voluntarily hold excess reserves.
- Homogeneous Banking System: The model assumes all banks are identical in terms of their lending behavior and risk appetite.
- No Leakages: The theory assumes there are no leakages in the money creation process. Leakages occur when individuals hold excess cash or banks hold excess reserves, reducing the amount of money available for lending.
- Closed Economy: The model typically assumes a closed economy, meaning there are no international capital flows.
Limitations of the Theory
In reality, the assumptions of the HPM theory often do not hold. Changes in the currency ratio, reserve ratios, and the emergence of new financial instruments can significantly affect the money multiplier and the effectiveness of monetary policy. For example:
- Financial Innovation: The development of new financial products like credit cards and digital payment systems can alter the currency ratio.
- Excess Reserves: During times of economic uncertainty, banks may choose to hold excess reserves, reducing the money multiplier. This was particularly evident after the 2008 financial crisis.
- Globalization: International capital flows can affect the domestic money supply, making it more difficult for the central bank to control.
Therefore, while the HPM theory provides a useful framework for understanding the relationship between the monetary base and the money supply, it is important to recognize its limitations and consider other factors that can influence monetary conditions.
Conclusion
The High-Powered Money theory offers a foundational understanding of how central banks can influence the money supply through controlling the monetary base. While the theory’s simplifying assumptions limit its predictive accuracy in the complex real world, it remains a valuable tool for analyzing monetary policy transmission mechanisms. Modern monetary policy often incorporates more sophisticated models that account for the behavioral changes and financial innovations that affect the money multiplier, recognizing that the relationship between HPM and the broader money supply is dynamic and not always predictable.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.